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Friday, September 29, 2006

Strings in the New Yorker

I think the article, which discusses the new books by Woit and Smolin, is very fair, and it ends with a surprisingly mature recapitulation of the decoupling theorem and the irrelevance of quantum gravity to applied science. Every man, woman and child should read it and then ask their local particle theorist for more clarification.

I've read chunks of Smolin's book and it's quite good, although not without flaws. I have to go back and reread it -- I picked it up in a bookstore and couldn't put it down for at least an hour. I found his discussion of finiteness of string perturbation theory confusing -- he represents Mandelstam as saying one thing in the main text, but the email quoted in the footnotes doesn't seem to back it up. If the analytic continuation is the only problem then it's not on worse footing than many other results in theoretical physics. But, then, what have D'Hoker and Phong (and my grad school colleague Nathan Berkovits) been up to all this time? If I believed in string theory I'd have to spend some time sorting this all out.

...Today, more than a decade after the second revolution, the theory formerly known as strings remains a seductive conjecture rather than an actual set of equations, and the non-uniqueness problem has grown to ridiculous proportions. At the latest count, the number of string theories is estimated to be something like one followed by five hundred zeros. “Why not just take this situation as a reductio ad absurdum?” Smolin asks. But some string theorists are unabashed: each member of this vast ensemble of alternative theories, they observe, describes a different possible universe, one with its own “local weather” and history. What if all these possible universes actually exist? Perhaps every one of them bubbled into being just as our universe did. (Physicists who believe in such a “multiverse” sometimes picture it as a cosmic champagne glass frothing with universe-bubbles.) Most of these universes will not be biofriendly, but a few will have precisely the right conditions for the emergence of intelligent life-forms like us. The fact that our universe appears to be fine-tuned to engender life is not a matter of luck. Rather, it is a consequence of the “anthropic principle”: if our universe weren’t the way it is, we wouldn’t be here to observe it. Partisans of the anthropic principle say that it can be used to weed out all the versions of string theory that are incompatible with our existence, and so rescue string theory from the problem of non-uniqueness.

...Neither Smolin nor Woit calls for the forcible suppression of string theory. They simply ask for a little more diversity. “We are talking about perhaps two dozen theorists,” Smolin says. This is an exceedingly modest request, for theoretical physics is the cheapest of endeavors. Its practitioners require no expensive equipment. All they need is legal pads and pencils and blackboards and chalk to ply their trade, plus room and board and health insurance and a place to park their bikes. Intellectually daunting as the crisis in physics may be, its practical solution would seem to demand little more than the annual interest on the rounding error of a Google founder’s fortune.

“How strange it would be if the final theory were to be discovered in our own lifetimes!” Steven Weinberg wrote some years ago, adding that such a discovery would mark the sharpest discontinuity in intellectual history since the beginning of modern science, in the seventeenth century. Of course, it is possible that a final theory will never be found, that neither string theory nor any of the alternatives mentioned by Smolin and Woit will come to anything. Perhaps the most fundamental truth about nature is simply beyond the human intellect, the way that quantum mechanics is beyond the intellect of a dog. Or perhaps, as Karl Popper believed, there will prove to be no end to the succession of deeper and deeper theories. And, even if a final theory is found, it will leave the questions about nature that most concern us—how the brain gives rise to consciousness, how we are constituted by our genes—untouched. Theoretical physics will be finished, but the rest of science will hardly notice.

Managing expectations

Kindler, gentler hedge fund manager Barry Ritholz writes about the Amaranth blowup. He puts some of the blame on investors, for not understanding that Amaranth had to be taking huge risks to generate recent outsized returns. The way the game is structured, managers are incentivized to describe their strategy and expected returns as follows:

"We expect gains of 35-45%, with minimal risk or leverage. Our black box algorithms have been backtested, and generate better numbers than that, but we would rather under-promise and outperform."



Before you roll your eyes, hear me out on this. I have some very specific experience with this, as I have spent the past 18 months or so traveling around the United States, speaking with my limited partners (i.e., investors) and with potential investors for our hedge fund.

My experience with this is why I have been watching the unfolding debacle at Amaranth Advisors’ with some bemused detachment.

Now, without revealing any specifics, I will tell you we have had conversations with some very intelligent people who were a pleasure to meet with; Brilliant, fascinating, successful folk with interesting lives and of great accomplishment. However, once we sat down with their financial advisors - lawyers - accountants, things became, well, repetitious. In every meeting, there were some variations on the same conversations; Its like there is some hedge fund due diligence form that makes everybody ask nearly identical questions:

What's your track record? (Good)
How much skin do you have in the game? (alot)
How is Alpha generated (our models keep us on the right side of the major trend, and avoid big counter-trend moves)
What do you think will happen to the economy and the market?
(I don't know, but here's an underappreciated possibility . . .)
What is your Gamma ? Sharpe Ratio? (I neither know nor care; This isn't a B-school exam)

Then comes the exact same question, which I (foolishly) answer honestly:

"What sort of performance are you looking for?"

I usually start with: "It depends upon what the market offers us; If we remain range-bound, it will be difficult to put up great numbers without a lot of leverage or a lot of risk (or both), and we don't do that. We do particularly well, however, in major dislocations or strong rallies."

My initial answer is rarely accepted, and I am forced to go to a 2nd and 3rd option:

"Give us more details on what you want to do. What performance would you be happy with?"

Answer two: "What we want is irrelevant; Its what we can reasonably do while still managing risk, and not overleveraging. Our goal is to outperform the S&P500 with less risk, and in the event the SPX is negative, still have positive expectancy (i.e., be up when the indices are down)."

"So you are a relative (rather than absolute) performance fund?"

Answer 2b: "Well, most funds actually are, despite their claims of absolute performance regardless of market conditions. Consider the mediocre performance numbers from most funds recently when the market's been range-bound. Its been pretty weak, and that's no coincidence. There are only a handful of true absolute performance funds with great long term track records (and if you are talking to me, its because you cannot get into them)."

Now comes THE QUESTION. This is the one that gets people into trouble:

"We are looking for a number. What should we expect from you in the first 2 years?"

What they want to hear is "I am going to do 30-40% annually, fully hedged."

I don't say that, because it isn't true. (God bless Jim Simons, who actually can honestly say that). That's what too many investors are looking for; its nothing more than the greed factor at work. They don't say it explicitly, but its true: We want you to outperform the long term S&P500 benchmark by 300-400% annually (and we don't care about mean reversion). We really don't care how you do it. We want outsized profits. WE WANT THE LATE 1990S AGAIN.

Money raisers and some GPs have long ago figured this out. You have a few choices: you can answer the investors' questions honestly -- or to quote Ray Davies, you can give the people what they want (or think they want):

"We expect gains of 35-45%, with minimal risk or leverage. Our black box algorithms have been backtested, and generate better numbers than that, but we would rather under-promise and outperform."

Of course, that statement will be nonsense for 99.8% of the people who utter it. The vast majority of funds will not out-perform the indices dramatically year after year. We were fortunate -- we ended up with investors who understood this; Then again, we are a small fund, and not a $9B giant.

There are some funds that aim to fill this niche. They use lots and lots of leverage, play the highest beta moves, load up on derivatives, put up good numbers for a stretch. Eventually, they do one of two things: They take on some risk management -- lower their volatility plays, reduce leverage, aim for more sustainable gains.

Or they blow up.

Not all of them, but enough. Something like 25% of all hedge funds every couple of years dissolve, go away, reform, pop up elsewhere. That's not a coincidence, either.

Wednesday, September 27, 2006

Cody's and The Price of Admission

I was in Berkeley over the weekend and saddened to learn that the Telegraph Ave location of Cody's Books has closed after 41 years. I spent countless hours there as a grad student, broadening my intellectual horizons thanks to the impeccable and wide-ranging tastes of their staff.

At their 4th street location (still in business, and right next to a Peet's Coffee), I had a chance to look at Daniel Golden's The Price of Admission, which I mentioned in an earlier post. Although most of the attention has gone to his expose of celebrity and super-rich admits, he devotes an entire chapter to the discrimination against Asians (the chapter is entitled something like Asians: the new Jews, recalling the Ivy League Jewish quotas in place as recently as 50 years ago). He recounts numerous cases of accomplished immigrant kids of humble origins (particularly a lot of Chinese or Korean strivers), inexplicably denied admission to top schools. He even collects crypto-racist quotes from anonymous admissions officers, to the effect of "these Asian kids are all alike -- strong scores and grades, science and music, but I can't really tell them apart." When will Asian-Americans wake up and defend their rights? There is enough evidence for a strong class action lawsuit.

Golden, a Harvard man, also devotes an entire chapter to extolling Caltech as a paragon of merit-based admisisons :-) The only problem is, he refers to it at the beginning of the chapter as just a small engineering school :-/

Saturday, September 23, 2006

US income inequality: caused by financiers and tech entrepreneurs

Income inequality in the United States is at historic highs, after significant increases in the last decade. For example, in 2003-2004 the average income of the top 1 percent of the population increased by 17 percent while that of the remaining 99 percent increased by only 3 percent in real terms.

It is important to understand this phenomenon in more detail: is there a widening nationwide gap between the rich and all others? Data on incomes by county covering the mid to late 1990's, from the government Bureau of Economic Analysis, shows an interesting geographical pattern. Most of the gains enjoyed by the top 1% came from a small number of counties. In particular, income increases at the top end in tech hotbeds Seattle and Silicon Valley, and finance capital New York City, account for almost all of the aggregate nationwide increase. If four counties in those regions are removed, there is almost no increase in inequality during that period.

So, the good news is there isn't a national phenomenon at work here (and, perhaps, Bush is not to blame -- at least, if tax cuts were the cause I would expect the effect to be more uniform geographically; future data will tell). Let me be the first to welcome our financier and tech entrepreneur overlords! :-)

Thursday, September 21, 2006

The gilded age in China

The Times reports on nouveau riche parents in China and the special classes and activities lavished on their kids, such as private golf lessons and a "junior MBA" course. This is in a country where rural kids often cannot complete their schooling due to lack of funds. More evidence of the overpowering march of globalization.

...Now the race starts early, with an emphasis not on ideology but on the skills and experiences the children will need in the elite life they are expected to lead. In addition to early golf training, which has become wildly popular, affluent parents are enrolling their children in everything from ballet and private music lessons, to classes in horse riding, ice-skating, skiing and even polo.

The intense interest in lifestyle training speaks not just to parents’ concern for their children’s futures but also to a general sense of social insecurity among China’s newly rich.

...FasTracKids [the "junior MBA" program], which started in Shanghai in 2004, has since opened two more outlets here and another in Guangzhou, and it is planning a fifth in Hangzhou.

The private program’s after-school sessions are held in brightly decorated classrooms, where fewer than a dozen children, typically 4 or 5 years old, are taught by as many as three teachers. The program emphasizes scientific learning, problem solving and, most attractively for many parents, assertiveness.

“Parents like myself are worrying about China becoming a steadily more competitive society,” said Zhong Yu, 36, a manufacturing supervisor whose wife is a senior accountant with an international firm and whose son 7-year-old son has been enrolled in the junior M.B.A. classes. “Every day we see stories in the newspapers about graduates unable to find good jobs. Education in China is already good in the core subjects, but I want my son to have more creative thinking, because basic knowledge isn’t sufficient anymore.”

Mr. Zhong said that for all of their high salaries, he and his wife had very demanding jobs with little leisure time, and the bottom line for them was “wanting our son to have a better life than we have had.”

To some extent, the trend is driven by a collision of rising affluence and China’s one-child policy, which forces parents to focus all their energy and resources on a single child. But experts say there is more at work, that it reflects fear of a new kind of rat race, in which the entire society is hustling for advancement.

“At the top of the pyramid will be exceptionally strong graduates from top American or European universities who become a sort of ‘international freemen,’ ” said Qiu Huadong, an author and editor who has written about the new elite. “They work several years in China, and then they go abroad for a while, shifting locations every few years. At the bottom of the pyramid will be those who didn’t get such an outstanding education, and they’ll be sweating and bleeding for China and globalization.”

Other experts say that for many others, the grooming schools, study abroad and lessons in elite sports like golf and polo are as much about a gnawing sense of social insecurity as they are about getting ahead.

“Americans respect people who came from nothing and made something of themselves, and they also respect rich people,” Mr. Wang added. “In China, people generally don’t respect rich people, because there is a strong feeling that they are lacking in ethics. These new rich not only want money, they want people to respect them in the future.”

Wednesday, September 20, 2006

The citadel of finance

Bloomberg is reporting that Citadel, another mega fund started by former physics major (Harvard) Ken Griffin, is negotiating to take over Amaranth's energy positions. In the case of Long Term Capital, the Fed convened an emergency rescue by a consortium of major banks. The banks bought Long Term's portfolio for pennies on the dollar, and eventually made a profit when spreads returned to historical values. Perhaps the only people hurt by this debacle will be Amaranth's investors. Brian Hunter, the trader responsible for the losses, took home a bonus reported to be $100M last year, so I suspect he will recover just fine.

Few appreciate modern finance, in all its complexity and volatility. Even among practioners, there is a wide range of opinions concerning the value of their profession.

Position 1: This stuff is bullsh*t. But it provides the best risk-adjusted economic return for my high powered brain.

Position 2: If we can improve the efficiency of capital markets and resource allocation by even a fraction of a percent, the benefit to society over time is enormous, albeit invisible to the casual observer.

Charlie Munger, Warren Buffet's long time investment partner, on the brain drain into finance:

I regard the amount of brainpower going into money management as a national scandal.

We have armies of people with advanced degrees in physics and math in various hedge funds and private-equity funds trying to outsmart the market. A lot of you older people in the room can remember when none of these people existed. There used to be very few people in the business, [and they were] who were not very intelligent. This was a great help to me.

Now we have armies of very talented people working with great diligence to be the best they can be. I think this is good for the people in it because if you know enough about money management to be good at it, you will know a lot about life. That part is good.

But it's been carried to an extreme. I see prospectuses for businesses with 40-50 people with PhDs, and they have back tested systems and formulas and they want to raise $100 billion. [Reference to Jim Simons of Renaissance Technologies.] And they will take a very substantial override for providing this wonderful system. The guy who runs it has a wonderful investment record and his system is a lot of high mathematics and algorithms with data from the past." [...]

"At Samsung, their engineers meet at 11pm. Our meetings of engineers (meaning our smartest citizens) are also at 11pm, but they're working on pricing derivatives. I think it's crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system."

Monday, September 18, 2006

Blowing up is hard to do

Shades of Long Term Capital Management! $5B gone in one month thanks to leverage. Please ignore that the trader responsible was a 32 year old with physics and applied math degrees ;-)

Big coverage in today's WSJ: here and here. Turns out that Hunter was a huge risk taker with a troubled history at Deutsche Bank, who left and made Amaranth $1B last year. From the first WSJ article:

...A graduate professor of his was a leader in the emerging field of financial modeling and derivatives.

Mr. Hunter joined TransCanada Corp., a Calgary pipeline company that was becoming a player in the growing business of trading energy, rather than simply transporting it. The company would help customers like gas producers lock in prices for some of the fuel it shipped for them.

Mr. Hunter, then 24, came armed with fresh theories about options pricing and impressed his bosses with his ability to spot price anomalies. They gave him increasing amounts of money to trade with after early successes. Among them: He convinced them that options in Canadian gas were underpriced as a pipeline from Canada to Chicago was set to open and create a greater market for it.

"He helped us prove that mathematically...and it paid off hugely," says Shondell Sabad, a former colleague there who now trades for a Calgary bank."

Bloomberg:

Amaranth Says Funds Lost 50% This Month on Gas Trades

By Katherine Burton and Matthew Leising
Sept. 18 (Bloomberg) -- Amaranth Advisors LLC, a hedge-fund manager with about $9.5 billion in assets, told investors its two main funds fell an estimated 50 percent this month because of a plunge in natural-gas prices.

``We are in discussions with our prime brokers and other counterparties and are working to protect our investors while meeting the obligations of our creditors,'' Nick Maounis, the 43-year old founder of the Greenwich, Connecticut-based firm, said in a letter to investors obtained by Bloomberg News. The funds, which had gained 26 percent through August, are down at least 35 percent for the year, or about $4.6 billion.

Amaranth, which made so-called spread trades that try to profit from price discrepancies among futures contracts, is at least the second hedge fund to be hurt by this year's tumble in natural gas. Last month, MotherRock LP, a $400 million fund run by former New York Mercantile Exchange President Robert ``Bo'' Collins, went bust after natural-gas futures fell 68 percent from
their Dec. 13 peak.

``The speed with which leveraged funds can evaporate is mind boggling,'' said Mark Williams, a professor of finance and economics at Boston University specializing in energy markets. Earlier this month, Amaranth, named for an imaginary flower that never fades, bought a portfolio of gas trades from ABN Amro Holding NV that the Dutch bank took over from MotherRock. ABN Amro had lent MotherRock $60 million, and is still owed money by the fund.

Margin Calls Met

Amaranth is ``near the end of our disposition of natural-gas exposure,'' the letter said, adding the firm had met all margin calls, or demands from brokers for additional collateral to cover loans. Steve Bruce, an Amaranth spokesman, declined to comment.

Gas prices fell 12 percent last week as the U.S. Energy Department reported stockpiles climbed 12 percent above last year's levels. Demand for the power-plant fuel usually declines after summer air conditioner use slows and before heating needs pick up.

Investors said the funds, Amaranth International and Amaranth Partners, wagered that the difference between futures prices for natural gas in the summer and winter months would continue to get larger, a trend that's held since at least the beginning of 2004. Futures are contracts to buy or sell a commodity on a specific date at a preset price.

Spreads Narrow

Instead, the spread collapsed. The difference in price between the 2007 March and April contracts for natural gas peaked in July at $2.60. That shrunk to $1.15 by the end of last week. The spread between the two was about 75 cents today on the New York Mercantile Exchange. Spreads between March and April contracts in 2008, 2009 and later have also collapsed.

Investors in Amaranth included fund-of-funds managed by Wall Street banks including Morgan Stanley, Credit Suisse Group and Deutsche Bank AG, according to U.S. Securities and Exchange Commission filings. As of June 30, Morgan Stanley's $2.3 billion Institutional Fund of Hedge Funds had $126 million, or 5.48 percent of the fund, invested in Amaranth.

The trader behind Amaranth's natural-gas bets is Calgary- based Brian Hunter, who is co-head of the firm's global energy and commodities business. As of June 30, energy trades accounted for about half of its funds' capital and generated about 75 percent of their profits.

New Fund

Before joining Amaranth, Hunter, 32, was responsible for Deutsche Bank AG's natural-gas trading desk from 2001 until 2004. Before joining Deutsche Bank he was an options trader and quantitative analysts for Transcanada Gas Services. Hunter graduated from the University of Alberta with a bachelor of science with honors in physics and a master of science in applied mathematics.

Maounis spun his firm off from Greenwich-based Paloma Partners in 2000. A convertible-bond specialist who worked at Paloma for 10 years, Maounis started Amaranth with 27 investment professionals and about $450 million in assets. The firm's initial strategies included trading convertible bonds and the stocks of merging companies.

Amaranth had recently been marketing an energy and commodities fund, slated to open in December, which it said had a capacity of $5 billion, according to a marketing document send to potential investors. The fund was to be managed by Hunter and Jeff Baird, co-head of Amaranth's Global energy and commodities business.

Perelmania II

I just received the following press release (?!?) from S.T. Yau's attorney (actually, via a public relations firm, presumably retained by Yau or his attorney). Nasar and Gruber's article on Perelman, Yau and the Fields medal was pretty tough on Yau, and I'm not very surprised by this response. If the authors and fact checkers can't substantiate all the nasty things said about Yau, they'll be quite sorry.

The formal complaint letter sent to the authors and the New Yorker is here. It is quite long and detailed.

Since I don't want to be sued, I'm not going to comment on any of this :-)

Harvard Math Professor Alleges Defamation by New Yorker Article; Demands Correction

Leading Math Scholars Decry Fictions Surrounding Fields Medal, Letter Says

BOSTON, September 18, 2006 – Pulitzer-prize winner Sylvia Nasar (“A Beautiful Mind”) defamed world renowned Harvard mathematics professor Dr. Shing-Tung Yau, in an article about a noteworthy mathematical proof in The New Yorker magazine entitled “Manifold Destiny” (August 28, 2006), according to a letter written by Dr. Yau’s attorney, Howard M. Cooper of Todd & Weld LLP of Boston. In the letter, Dr. Yau has demanded that The New Yorker and Nasar make a prominent correction of the errors in the article, and apologize for an insulting illustration that accompanied it.

“Beyond repairing the damage to my own reputation, we seek to minimize the damage done to the mathematics community itself, which is ludicrously portrayed as contentious rather than cooperative and more competitive than collegial,” Dr. Yau said. “Mathematicians from the foremost institutions – from Beijing to Berkeley – have been appalled at the fictionalizing of our profession.”

The attorney letter alleges that Ms. Nasar misrepresented her intentions in emails to him in which she claimed an interest in the “reuniting of physics and mathematics” and that she had been impressed with praise of his work from Stephen Hawking. Never during the three months in which she worked on the article, according to the letter, was Dr. Yau made aware of or asked to respond to charges leveled against him in the published article, claiming that Dr. Yau was trying to take credit for the solution of the Poincar√© Conjecture away from Russian mathematician Grigory Perelman. Contrary to the article, there has never been a ‘battle’ over credit for the solution, said the letter. Many of the other scholars interviewed by Ms. Nasar report being similarly deceived, according to the letter, with one professor at the University of Michigan comparing her work to that of the notorious fabricator, Jason Blair of The New York Times.

Shing-Tung Yau, a professor at Harvard since 1987, who himself received a Fields Medal in 1982, holds today the nation’s highest science award, the National Medal of Science, awarded in 1997 for his "profound contributions to mathematics that have had a great impact on fields as diverse as topology, algebraic geometry, general relativity, and string theory. His work insightfully combines two different mathematical approaches and has resulted in the solution of several longstanding and important problems in mathematics."

The allegations made in the letter will be discussed in detail in a webcast open to all interested parties scheduled for Noon EDT, Wednesday, September 20, 2006. Log in information will be posted on www.doctoryau.com. The letter sent to The New Yorker is available at his website.

Sunday, September 17, 2006

Neuroeconomics

Very nice article in the New Yorker summarizing recent research. Your inner lizard brain is loss averse and reacts emotionally to unfair bargains. Monkey brains are good at mathematical optimization in the face of uncertainty, despite not "understanding" probability. Economists and psychologists have rediscovered the age old observation that reason and emotion compete within the brain, but now they know where the various activities occur.

The article is quite long, and worth readng in full. I only excerpt a few things below. Given pieces like this, and the big scoop on Perelman, why would anyone not subscribe to the New Yorker? :-)

...When people make investments, they weigh the possible outcomes of their decisions and select a portfolio of stocks and bonds that offer the highest possible return at an acceptable level of risk. That is what mainstream economic says, anyway. In fact, people often have only vague idea of the risks they face. ...

As imaging technology gets more sophisticated and easier to use, it may become possible to monitor investors’ brains while they trade stocks at their offices. ... In one study, Camerer and several colleagues performed brain scans on a group of volunteers while they placed bets on whether the next card drawn from a deck would be red or black. In an initial set of trials, the players were told how many red cards and black cards were in the deck, so that they could calculate the probability of the next card’s being a certain color. Then a second set of trials was held, in which the participants were told only the total number of cards in the deck.

The first scenario corresponds to the theoretical ideal: investors facing a set of known risks. The second setup was more like the real world: the players knew something about what might happen, but not very much. As the researchers expected, the players’ brains reacted to the two scenarios differently. With less information to go on, the players exhibited substantially more activity in the amygdala and in the orbitofrontal cortex, which is believed to modulate activity in the amygdala. “The brain doesn’t like ambiguous situations,” Camerer said to me. “When it can’t figure out what is happening, the amygdala transmits fear to the orbitofrontal cortex.”

The results of the experiment suggested that when people are confronted with ambiguity their emotions can overpower their reasoning, leading them to reject risky propositions. This raises the intriguing possibility that people who are less fearful than others might make better investors, which is precisely what George Loewenstein and four other researchers found when they carried out a series of experiments with a group of patients who had suffered brain damage.

Each of the patients had a lesion in one of three regions of the brain that are central to the processing of emotions: the amygdala, the orbitofrontal cortex, or the right insular cortex. The researchers presented the patients with a series of fifty-fifty gambles, in which they stood to win a dollar-fifty or lose a dollar. This is the type of gamble that people often reject, owing to loss aversion, but the patients with lesions accepted the bets more than eighty per cent of the time, and they ended up making significantly more money than a control group made up of people who had no brain damage. “Clearly, having frontal damage undermines the over-all quality of decision-making,” Loewenstein, Camerer, and Drazen Prelec, a psychologist at M.I.T.’s Sloan School of Management, wrote in the March, 2005, issue of the Journal of Economic Literature. “But there are situations in which frontal damage can result in superior decisions.”

...A good way to illustrate Cohen’s point is to imagine that you and a stranger are sitting on a park bench, when an economist approaches and offers both of you ten dollars. He asks the stranger to suggest how the ten dollars should be divided, and he gives you the right to approve or reject the division. If you accept the stranger’s proposal, the money will be divided between you accordingly; if you refuse it, neither of you gets anything.

How would you react to this situation, which economists refer to as an “ultimatum game,” because one player effectively gives the other an ultimatum? Game theorists say that you should accept any positive offer you receive, even one as low as a dollar, or you will end up with nothing. But most people reject offers of less than three dollars, and some turn down anything less than five dollars.

Cohen and several colleagues organized a series of ultimatum games in which half the players—the respondents—were put in MRI machines. At the beginning of a round, each respondent was shown a photograph of another player, who would make the respondent an offer. The offer then appeared on a screen inside the MRI machine, and the respondent had twelve seconds in which to accept or reject it. The results were the same as in other, similar experiments—low offers were usually vetoed—but the respondents’ brain scans were revealing.

When respondents received stingy offers—two dollars for them, say, and eight dollars for the other player—they exhibited substantially more activity in the dorsolateral prefrontal cortex, an area associated with reasoning, and in the bilateral anterior insula, part of the limbic region that is active when people are angry or in distress. The more activity there was in the limbic structure, the more likely the person was to reject the offer. To the researchers, it looked as though the two regions of the brain might be competing to decide what to do, with the prefrontal cortex wanting to accept the offer and the insula wanting to reject it. “These findings suggest that when participants reject an unfair offer, it is not the result of a deliberative thought process,” Cohen wrote in a recent article. “Rather, it appears to be the product of a strong (seemingly negative) emotional response.”

Several explanations have been proposed for people’s visceral reaction to unfair offers. Maybe human beings have an intrinsic preference for fairness, and we get angry when that preference is violated—so angry that we punish the other player even at a cost to ourselves. Or perhaps people reject low offers because they don’t want to appear weak. “We evolved in small communities, where there was a lot of repeated interaction with the same people,” Cohen said. “In such an environment, it makes sense to build up a reputation for toughness, because people will treat you better next time they see you.”

.... Today most economists agree that, left alone, people will act in their own best interest, and that the market will coördinate their actions to produce outcomes beneficial to all.

Neuroeconomics potentially challenges both parts of this argument. If emotional responses often trump reason, there can be no presumption that people act in their own best interest. And if markets reflect the decisions that people make when their limbic structures are particularly active, there is little reason to suppose that market outcomes can’t be improved upon.

Consider saving for retirement. Surveys show that up to half of all families end their working lives with almost no financial assets, other than their entitlement to Social Security benefits. Saving money is difficult, because it involves giving up things that we value now—a new car, a vacation, fancy dinners—in order to secure our welfare in the future. All too often, the desire for immediate gratification prevails. “We humans are very committed to our long-term goals, such as eating healthy food and saving for retirement, and yet, in the moment, temptations arise that often trip up our long-term plans,” David Laibson, the Harvard economist, said. “I was planning to give up smoking, but I couldn’t resist another cigarette. I was planning to be faithful to my wife, but I found myself in an adulterous relationship. I was planning to save for retirement, but I spent all my earnings. Understanding this tendency stands at the heart of a lot of big policy debates.”

...There is also a more fundamental objection to neuroeconomics and the Platonic view of decision-making. “There is no evidence that hidden inside the brain are two fully independent systems, one rational and one irrational,” Paul W. Glimcher, a neuroscientist who is the director of N.Y.U.’s Center for Neuroeconomics, and two of his colleagues, Michael C. Dorris and Hannah M. Bayer, wrote in a recent paper. “There is, for example, no evidence that there is an emotional system, per se, and a rational system, per se, for decision making at the neurobiological level.”

In place of the reason-versus-passion model, Glimcher and his colleagues have adopted a view of decision-making that, paradoxically, bears a striking resemblance to orthodox economics. In one experiment, Glimcher and a colleague trained thirsty monkeys to direct their eyes to one of two illuminated targets, which earned them differing chances of getting juice rewards—a fifty-per-cent chance of getting a full cup of juice for looking right, say, versus a seventy-per-cent chance of getting half a cup of juice for looking left. The game was repeated many times, with the probabilities changing periodically.

The monkeys’ task was to consume as much juice as possible, and they proved very adept at it. Before long, they were dividing their time between the illuminated targets in a way that roughly maximized their payoffs. When the odds favored looking right, they looked right; when the odds favored looking left, they looked left. Glimcher also used electrodes to track neural firing in part of the posterior parietal cortex, an area that is thought to organize signals transmitted by the retina. He discovered that the firing rate was closely related to the rewards the monkeys were likely to receive. “Specifically,” he and his colleagues reported, “the firing rate of a neuron associated with a leftward movement was a linear function of the probability that the leftward movement would yield the juice reward.”

Clearly, monkeys can’t do probability sums. (Many humans struggle with them!) But Glimcher’s experiment implies that their brains act as if they were solving a mathematical problem, which is what economists assume when they depict people as rational agents trying to maximize their well-being, or “utility.” “What seems to be emerging from these early studies is a remarkably economic view of the primate brain,” Glimcher and his colleagues wrote. “The final stages of decision-making seem to reflect something very much like a utility calculation.”

If Glimcher’s results could be demonstrated in human brains, they might undermine a lot of neuroeconomics, and many in the field tend to downplay his work. “Well, monkeys are very interesting, but they are not nearly as rich in their behavior as humans,” George Loewenstein said to me. “Humans have this very well-developed prefrontal cortex, which allows us to look ahead a number of stages, rather than just behaving in a reflexive fashion. Still, it’s wonderful that we have these controversies. Most of us are friends, and we debate these issues. I’ve learned a lot from talking to Paul.”

Saturday, September 16, 2006

WSJ on SAC

Stevie Cohen is profiled in this long WSJ article. He's had an uncanny intuition for predicting short term market movements. But he seems uneasy about the future...

On a typical day, SAC's trading accounts for 2% of overall stock-market activity...

SAC is among the most widely watched investment firms in the world. Mr. Cohen, who is 50 years old, has always guarded his privacy fiercely, keeping mum as attention was heaped upon his trading tactics, his voracious art collecting, and his expanding Greenwich, Conn., estate. Recently, in a series of interviews at his Stamford office, Mr. Cohen discussed the rise of SAC Capital, the suspicions of improper trading that have dogged his firm, and the big shift in his view of investing.

Mr. Cohen says he is now making bigger bets and holding the stocks longer. The throng of rival hedge funds could create a dangerous logjam, he says. Mr. Cohen worries that some of his largest holdings are also favored by other hedge funds. A rush for the exit could spell trouble. He says he expects that eventually there will be a sudden and sharp reversal in the stock market -- but he's not worried about that happening this year. "There will be a real decline that may devastate hedge funds that have crowded into the same stocks," he predicts.

"Hedge funds are bigger than they used to be. Their positions are bigger," he says. "I worry that if everyone were to sell, could we get out?"

Hedge funds, private investment pools for institutions and well-heeled individuals, now hold about $1.2 trillion in assets, more than twice what they had five years ago. Fat returns are becoming more elusive. In 2005, the average hedge fund returned 9.3%, below the 11.4% average for the past decade, according to Hedge Fund Research Inc., a Chicago consultant. By comparison, the S&P 500 index returned 7.7% last year. A record 848 hedge funds closed up shop in 2005, many of them hobbled by poor performance, according to Hedge Fund Research.

Mr. Cohen's reputation rests on an investing style altogether different from the buy-and-hold strategy espoused by influential investors such as Warren Buffett. Mr. Cohen believes that by scrutinizing trading patterns of a stock -- by "watching the tape" -- it is often possible to predict how the stock will move in the coming hours or even days. For years, he jumped in and out of stocks -- sometimes without any knowledge of a company's fundamentals, or even what it did. It was akin to picking out rocks in a river by watching the currents swirl around them.

Classic "value" investors such as Mr. Buffett insist that what other traders are thinking and doing is of no consequence to sound investing. Mr. Cohen is his polar opposite. He spends long days at the office in black jeans and worn sweaters, glued to his computer screens as he personally trades upwards of 300 stocks. SAC's trading floor bombards him with information about what's going on in the market. He soaks it all up. His eyes are often rimmed with fatigue.

On a typical day, SAC's trading accounts for 2% of overall stock-market activity. SAC pays securities firms an average of one cent for each share it trades, which adds up to more than $400 million in trading commissions each year, making SAC one of Wall Street's best clients.

For years, the relentless trading was highly effective. SAC Capital Management LP, Mr. Cohen's largest and oldest fund, launched in 1992, has generated an average annual return to investors of 43.5%, after he takes a sizable cut of profits. He and his partners keep 50% of that fund's gains, along with a 3% annual fee, far more than the 20% and 2% charged by most managers.

Mr. Cohen's colossal compensation inspired cocky traders who figured they could do the same, and dismayed others who disdained the frenetic momentum-style investing that underpinned the bull market of the 1990s. His net worth is estimated at about $3 billion, which SAC does not dispute.

In 1998, Mr. Cohen and his second wife, Alex, 42, bought his gated 1920s fieldstone estate for $14.8 million. They added a 12,000-square-foot annex with a basketball court and an indoor pool, and an outdoor skating rink. They constructed a 20-seat movie theater and decorated the ceiling of its lobby with the pattern of stars on their wedding night 16 years ago. Outside, they laid out a two-hole golf course, formal gardens and an organic vegetable plot.

They bought $700 million of art and adorned the estate with some of the pieces. A Keith Haring sculpture of three painted aluminum dancing figures stands out front. A $52 million Jackson Pollock hangs in the library. A Van Gogh and a Gauguin, both bought recently for a total of $100 million, grace the living room. An Andy Warhol and a Roy Lichtenstein hang in the foyer.

The spending spree fueled carping that new hedge-fund wealth was altering the fabric of Greenwich, long a home for the very rich.

...Mr. Cohen says he worries about whether SAC's investments are beginning to look like those of any other hedge fund. What's worked for SAC in recent years, he says, may not work going forward.

On June 9, around midday, Mr. Cohen walked off SAC's trading floor and slumped into a chair. The markets had been choppy all week. He was growing more certain that stocks were in for a significant decline, but ventured that it was more than a year away.

"The hedge-fund run is not over," he said. "I think the game is changing, and if it is, I have to react. We won't go off the ledge with everyone else."

Tuesday, September 12, 2006

The real world

I'm back in Eugene, and very jetlagged. Quite disorienting, the past week. I went from a physicist enclave in a mediterranean walled city which dates to 800 BC, to the luxotopia of Manhattan island, to the eco-hippy university town in the pacific northwest I call home :-) Which one is the real world?

Yesterday, waiting for a lunch meeting, I met an old friend for coffee. We wandered into the recently renovated MOMA in midtown, with its quiet sculpture garden. His employer, like all the big banks, is a major donor, and his ID card gained us immediate entry. Manhattan is like a big amusement or theme park for financiers. Relative to their compensation, all the rides (taxis, restauarants, everything but real estate) are free! See the drivers in big black sedans dropping off perfectly groomed, uniformed children at their $25k/y private schools, where the headmistress greets each child by name.

Today someone added the following comment to an old post on this blog entitled Don't become a scientist:

What about your children?

I'm a phd physicist who loves his work... but is dreading the day when he has to tell his kids they'll be going to UMaryland instead of Princeton because daddy loved his work too much. Grass is always greener, I guess... but... when you're 34 and trying to raise a family on what amounts to a lower-middle class scientist salary... you have a tendency to wonder why you didn't chose the path of the lawyers who process the paperwork for your patents. After all, they make a lot more money on my intellectual property than I do.

Sunday, September 10, 2006

Back in the gilded age USA

Stopped in NYC on the way home. Great to be back in the states. Perhaps I am being unfair but Europe looked a bit backward and run down by comparison.

Has the world gone mad? A late night sashimi snack for three physicists (two now in finance) can run to $300 on the upper east side, despite amounting to less than 1000 kcal per person. What do the wait staff think of conversations peppered with terms and phrases like "global macro", "Eric Mindich", "they only raised $200M -- think of the opportunity cost", "they're like Susquehanna, only 15 years ago"? Today I noticed that the ratio of trainers to rich yuppies at the gym is approaching one to one.

Best signal of a popped bubble? The Times has launched a magazine called Key devoted completely to real estate. Bad timing, I think :-)

The WSJ has a great article excerpted from Daniel Golden's book on college admissions, which points out how Brown and Duke rose to prominence by admitting underqualified celebrity or rich kids in order to build their brand and endowment. What can I say? It's a winning strategy. There are no legacy admits at Caltech. Hopefully that won't stop them from getting a few million from the guys I had dinner with last night.

What makes Duke and Brown, among other institutions, stand out, is the way in which they ramped up and systematized their pursuit: rejecting stronger candidates to admit children of the rich or famous, regardless of their ties to the university.

...Brown raised its profile by enrolling children or stepchildren of politicians and celebrities, including two presidents, three Democratic presidential nominees, two Beatles and seven Academy Award winners. A particularly controversial case was the son of Hollywood superagent Michael Ovitz, whose application sparked a debate within Brown.

Celebrity students generally lag behind their classmates in academic honors. But their prominence -- and that of their parents -- helped transform Brown into a top destination for students with a creative or artistic bent. Brown accepted just 13.8% of applicants for this year's freshman class, the lowest percentage in its history, as the number of applications rose sharply. Its endowment has risen from 29th nationwide in 1980 ($123 million) to 26th in 2005 ($1.6 billion), although it remains the lowest in the Ivy League.

This success, however, carries a cost. As the number of applicants has soared in recent years, premier schools admit as few as one in 10 students, a far more selective rate compared with a generation ago. To make room for an academically borderline development case, a top college typically rejects nine other applicants, many of whom might have greater intellectual potential.

Some colleges have been known to accept all applicants from a given high school to conceal the development admit, and thereby avert criticism from rejected students. Known in the trade as "considering context," the practice shortchanges worthy applicants from other high schools who might otherwise have made the grade.

Friday, September 08, 2006

Still in Sicily

The Erice meeting has ended, but I'm still here for a couple of days. Yesterday I rented a car with two colleagues and drove to Agrigento to see some impressive Greek temples and have a traditional Sicilian seafood dinner. Now I'm back in the mountains trying to understand some things about AdS/CFT duality.

My collaborator Xavier Calmet won a prize for best theoretical presentation (students and postdocs were allowed to give short talks). I was among the people deciding on prizes, so I was careful not to vote on that one. Xavier's talk was on how a minimal length arises from simple quantum mechanics and general relativity. I think its accessibility was the primary reason for the prize :-)

Although I've been mostly thinking about physics the last week, I've been getting some interesting emails about the deterioration of the US housing market. It seems official data from OFHEO and the census bureau very much understates what is happening. Some of the data showing that we've passed the peak of the bubble are quite dramatic. The next couple of years will be a buyer's market. The open question is of course how the housing collapse will affect the overall economy. It's worth noting that there is a cap on bond returns, since if the economy really tanks, and 10y yields decrease below, say, 4.5 percent, the housing market may reinflate again due to low interest rates. Since 10y yields are currently at 4.8, the maximum capital gain is probably less than 10 percent.

Tuesday, September 05, 2006

String Landscape, AI and virtual worlds

The Landscape lectures at Erice are over. I'm not very optimistic about the anthropic principle --- for example, see my paper with Graesser, Jenkins and Wise on how even Weinberg's original anthropic prediction of the cosmological constant is critically sensitive to the assumed level of initial density perturbations. Nevertheless I learned something interesting from Lenny's lectures. Since the Landscape involves many metastable vacua, it is very likely that our universe, with its small vacuum energy, was produced via bubble nucleation from a parent universe with much larger vacuum energy. In this case it is unavoidable that the spatial geometry of our universe has negative curvature. A subsequent era of inflation can reduce this negative curvature to almost zero, but there is a definite prediction that k is negative. If an observation by Planck (next generation CMB probe after WMAP) yields a small positive k, the Landscape will be strongly disfavored. By the usual Popperian definition, the Landscape is then science: it makes a falsifiable prediction! (Lenny, being quite honest, confided that Andre Linde would almost certainly find a way out, but it would have to be quite contrived :-)

[See more recent post here. The prediction of negative curvature isn't as robust as I had originally thought. 10.24.2006]

Having argued that the Landscape is sort of falsifiable, let me now turn to a reductio ad absurdum of anthropic arguments.

Let R = the ratio of number of artificially intelligent virtual beings to the number of "biological" beings (humans). The virtual beings are likely to occupy the increasingly complex virtual worlds created in computer games, like Grand Theft Auto or World of Warcraft (WOW will earn revenues of a billion dollars this year and has millions of players). In the figure below I have plotted the likely behavior of R with time. Currently R is zero, but it seems plausible that it will eventually soar to infinity. (See previous posts on the Singularity.)



If the integral of R diverges, then anthropic reasoning suggests that we are overwhelmingly likely to be virtual beings living in a virtual world. The electron mass and string flux compactification parameters were set by a programmer (himself virtual) working for a game company within yet another simulated world :-)

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